How to Identify the End of a Trading Chart Trend with the Moving Average Level Rule

When looking at a trading price chart, you can call the end of a trend by using the moving average level rule: an uptrend when the moving average today is less than the moving average yesterday, and a downtrend when the moving average today is higher than yesterday’s.

A moving average always lags the price action. In this figure, look at the prices and moving average in the left-hand ellipse. From the peak close, it takes the price six days to cross below the moving average — and ten days for the value of the moving average to be lower than the day before. By the time the moving average puts in a lower value than the day before, it’s Day 10 and the price has fallen from $82.49 to $75.38, or by 8.6 percent.

image0.jpg

But despite giving up 8.6 percent from the highest close while you wait for the moving average to catch up with prices, to trade this stock by using this indicator during this period would have been profitable.

The black arrows on the chart in the preceding figure mark the buy/sell entry and exit points, using the moving average level rule. You buy and sell at the open the day after the moving average meets the rule.

This table shows the profit you make by applying the rule. Your gain is $43.07 on an initial capital stake of $71.05, or 61 percent, compared to 14 percent if you buy on the first date and account for the gain on the last date (called mark-to-market).

Hypothetical Profit from the Moving Average Level Rule
No. of Days Action Price Level Rule Profit Buy-and-Hold
22 days Buy $71.05 $71.05
Sell $78.24 $7.19
42 days Sell $78.24
Buy $61.54 $16.70
29 days Buy $61.54
Mark-to-market $80.72 $19.18 $80.72
Total $43.07 (61%) $9.67 (14%)

Mark-to-market gains are named unrealized, and it’s a good phrase, meaning that the gain is only an accounting convention — and not real, although in futures trading, you may use unrealized gains to add to positions. Needless to say, a mark-to-market valuation is valid only until the next market price becomes available.

Be on the lookout for trading system vendor performance track records that rely on mark-to-market gains for wonderful end-of-period gains. Mark-to-market gains are only paper gains and can vanish in a puff of smoke. To evaluate a technique, look at its performance on closed trades.

blog comments powered by Disqus
Advertisement

Inside Dummies.com

Dummies.com Sweepstakes

Win $500. Easy.